Categories Consumer, Earnings Call Transcripts, Retail

Burlington Stores, Inc. (BURL) Q3 2020 Earnings Call Transcript

BURL Earnings Call - Final Transcript

Burlington Stores, Inc. (NYSE: BURL) Q3 2020 earnings call dated Nov. 24, 2020

Corporate Participants:

David J. Glick — Senior Vice President of Investor Relations and Treasurer

Michael O’Sullivan — Chief Executive Officer

John Crimmins — Executive Vice President and Chief Financial Officer


Matthew Boss — JPMorgan — Analyst

Ike Boruchow — Wells Fargo Securities — Analyst

John Kernan — Cowen & Company — Analyst

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Kimberly Greenberger — Morgan Stanley — Analyst



Ladies and gentlemen, thank you for standing by. And welcome to the Burlington Stores Incorporated Third Quarter 2020 Earnings Webcast Call. [Operator Instructions] After the speaker presentation, there will be a question-and-answer session. [Operator Instructions]

I would now like to hand the conference over to your speaker today, David Glick, Senior Vice President of Investor Relations and Treasurer. Please go ahead, sir.

David J. Glick — Senior Vice President of Investor Relations and Treasurer

Thank you, operator and good morning everyone. We appreciate everyone’s participation in today’s conference call to discuss Burlington’s fiscal 2020 third quarter operating results. Our presenters today are Michael O’Sullivan, our Chief Executive Officer and John Crimmins, Chief Financial Officer.

Before I turn the call over to Michael, I would like to inform listeners that this call may not be transcribed, recorded or broadcast without our expressed permission. A replay of the call will be available until December 1, 2020. We take no responsibility for inaccuracies that may appear in transcripts of this call by third parties. Our remarks and the Q&A that follows, are copyrighted today by Burlington Stores.

Remarks made on this call concerning future expectations, events, strategies, objectives, trends or projected financial results, are subject to certain risks and uncertainties, actual results may differ materially from those that are projected in such forward-looking statements. Such risks and uncertainties include those that are described in the company’s 10-K for fiscal 2019 and in other filings with the SEC, all of which are expressly incorporated herein by reference.

Please note that the financial results and expectations we discuss today are on a continuing operations basis. Reconciliations of the non-GAAP measures we discuss today to GAAP measures are included in today’s press release.

Now, here is Michael.

Michael O’Sullivan — Chief Executive Officer

Thank you, David. Good morning everyone and thank you for joining us on this morning’s third quarter earnings call. We are very glad that you could be with us. We are going to structure this mornings discussion as follows: first, review our third quarter results; second, I will talk about the outlook for Q4; third, I will describe how we are thinking about the post pandemic world and what actions we are taking to prepare for it. After that, I will hand the call over to John to walk through the financial details. Then, we will be happy to respond to any questions.

Okay, let’s start with the third quarter. Our comparable store sales performance in the third quarter exceeded our expectations at down 11% versus last year. I think it is important to break down this comp performance in more detail, than we normally would. As we came into the quarter, the trend was very weak and comp store sales for August ended down more than 20%. The weak trend in August was driven by two main factors: firstly, as we came into the third quarter, our in-store inventory position was well below where we wanted it to be. We discussed the underlying reasons for this in our second quarter earnings call. It was not until the end of August that in-store inventories reached planned levels.

Secondly, back-to-school is typically the dominant driver of traffic into our stores in early Q3. This traffic did not materialize in August and for a while, we did not know if back-to-school would happen at all. Once we got through August, both of these factors turned around. By early September, our in-store inventory levels had recovered and the back-to-school traffic that we had expected in August, finally showed up in September.

Our baseline plan for Q3 have been minus 20% comp, but in September and October, we chased the trend to minus 4% comp for the combined two-month period. Our gross margin in Q3 was up approximately 260 basis points, this was driven by higher markup and by lower markdowns. The buying environment in Q2 and Q3 was very strong and our merchants took advantage of great opportunistic deals. These deals allowed us to successfully pass along terrific value to the customer. We were pleased with our Q3 markup performance, but we do not believe that this higher markup is sustainable. As the buying environment normalizes, our goal will be to continue to use opportunistic buying to offer great value and thereby drive sales. But we do not expect to capture higher markup as a normal course of business.

The other key driver of our improved gross margin was a faster inventory turn and lower markdowns. Again, there were certain aspects of Q3 that were very unusual and that contributed to this improvement. We do not expect to achieve a similar level of markdown improvement in the fourth quarter.

I would like to turn now to the sales outlook for the fourth quarter. Unfortunately, the environment remains very unpredictable. In fact, the situation across the country with COVID-19 appears to be deteriorating. This is happening at the worst possible time for retail. The fourth quarter has gotten off to a weak start with November month-to-date comp running down in the low double-digits. Our assessment is that this initial weak trend has been driven by unseasonably warm weather, rather than by COVID. Typically, we would expect this impact to turn around later in the quarter, but there is risk that by then the resurgence in COVID-19 cases may have undermined and already fragile trend. Candidly, we just don’t know.

But again, just like Q3, we need to be prepared for a wide range of possible outcomes. We are tightly controlling our inventories and liquidity. We will remain very flexible, either to pull back or to chase the sales trend. Together with everyone else on this call, we have been following the positive news on potential vaccines with great interest. This positive news suggest that the end of the pandemic is within sight. But realistically, this probably means that it will be the second half of 2021 before the retail environment starts to feel normal again.

I would like to use the next few minutes to talk about how we are thinking about the post pandemic world and more importantly what actions we are taking to prepare for it. As I have discussed on previous calls in some important respects, we do not think that once we get through the pandemic, the world will just revert to the way it was. Our view is that the aftermath of the pandemic will lead to an acceleration in a couple of very important trends. Trends that have been evident for some time.

Firstly, the consumer desire and need for value; and secondly, the growth of e-commerce at the expense of full-price bricks-and-mortar retailers. We expect these trends to drive further rationalization of full-price bricks-and-mortar retail over the next several years. As these physical stores close, we expect that some shoppers, especially more affluent time-starved shoppers, will migrate more of their spending online. But, we anticipate that other shoppers, value-oriented shoppers, will find their way to off-price. This is consistent with what has actually been happening over the last several years. E-commerce has been growing rapidly and bricks-and-mortar off-price retail has been growing in parallel.

In the categories where we compete, and at the low price points that we offer, e-commerce is much less effective or competitive in meeting the needs of value-oriented shoppers. As the store closings that I have described play out, there will be an opportunity for bricks-and-mortar off-price retail to gain significant share.

Our priority at Burlington, as the smallest, least developed and least profitable, of the major off-price retailers, is to position ourselves to take advantage of this opportunity. We have talked in the past about Burlington 2.0, our off-price full potential strategy. The core objective of Burlington 2.0 is to significantly improve how we execute the off-price model.

I would like to use our Q3 results to describe some of the ways in which Burlington 2.0 is already having an impact on the business. To be clear, no one at Burlington will ever be happy with the decline in comp store sales, but there were some positive aspects of this performance to call out.

Number one, in the summer, our merchants did a great job going after tremendous opportunistic buys. As these receipts finally arrived in stores, they ignited the sales trend in early September.

Number two, we then chased this sales trend, we controlled and channeled our liquidity to go after the strongest merchandise categories and to shift the assortment. The overriding focus was on offering wow value.

Number three, in our supply chain and in our stores, we put huge emphasis and urgency on getting the fresh receipts through the system and out to the sales floor, this worked. Despite significant ahead-of-plan sales, in-store inventories came in almost exactly on plan at the end of Q3.

Number four, we managed these inventory levels deliberately and conservatively, driving the ahead-of-plan sales through a faster turn and thereby driving lower markdowns.

Overall, I am pleased with these aspects of our performance. I see them as early signs of progress with Burlington 2.0. We can and we will get better. This improved execution of the off-price model will be very important as we position ourselves for the post-pandemic world and the opportunities that lie ahead of us.

The things that I have just talked about, much greater focus on value, tighter liquidity control, lower inventories and more urgency in receipt flow, as I’ve described, these are already important and growing aspects of how we are managing the business. But there are other aspects of Burlington 2.0 that are at a much earlier stage of development or implementation.

I would like to share some high level updates on three of these: marketing, merchandising and our store prototype. First of all, marketing; our marketing team has done some great work this year, looking at how we can communicate a stronger, much more direct, off price value message and how we can deliver this communication in a more targeted and cost effective way. We will start to rollout these changes in Q4. We believe that this new marketing program will help to leverage our marketing reach and spend in the years ahead.

Secondly, our merchandising organization, as we have discussed in the past, we believe that the key enabler of better execution in the off-price model and driving growth in our business is to invest in our merchandising capabilities. I am very excited about the organizational growth plan that we have developed for our buying and planning group. It involves a combination of external hires, and very importantly, the development and promotion of internal talent.

In terms of external hires, we are pleased and somewhat surprised that the number and quality of candidates, that we have successfully interviewed, hired and on-boarded this year, despite the pandemic. We are also excited about the pipeline of external candidates. There are two factors that are helping us. The pandemic itself is obviously causing major disruption in the retail industry. This is freeing up some terrific merchandising talent and experience.

Secondly, we have an extremely compelling story. As the smallest of the major off-price retailers, we have a lot of growth ahead of us. In many merchandising categories, the company is at a relatively early stage of its development and talented merchants and planners, who joined our team now have a great opportunity to participate in our growth and at the same time, drive their own personal and professional development in the years to come.

The other critical aspect of our organizational growth plan is the development of internal talent growing our own. We have a lot of high-potential talent in our merchandising and planning organization. I’m excited to see this talent grow and take on more responsibility. Internal promotions are a key part of our organizational plan. We have stepped up our training and development programs this year and we have plans to do much more over the next few years.

The third aspect of Burlington 2.0, that I would like to update you on, is our store prototype. As we have discussed in the past, we believe that we have an opportunity to significantly improve store level productivity and economics by further reducing the size of our stores. Our real estate, and store operations teams have done a lot of work in the past year on a 25,000 square foot store prototype. We feel good about the merchandising and operational plans that we have developed for this smaller prototype.

We expect the economics of this format to be very favorable and we anticipate that it will become a central part of our new store opening and relocation programs, especially from 2022 onwards. We will be finalizing these plans over the next several months, and we expect to have more details to share with you in our fourth quarter earnings call in March 2021.

At this point, I would like to turn the call over to, John to provide more detail on our financials.

John Crimmins — Executive Vice President and Chief Financial Officer

Thanks Michael and good morning everyone. Let me start with the review of the income statement. For the third quarter, total sales decreased 6%, while comparable store sales decreased 11%. As Michael described earlier, our comparable store sales improved significantly after our inventories recovered to more appropriate levels at the end of August. We believe, this improvement was driven by our improved inventory position, the delay in back-to-school purchases and the outstanding values offered to our customers from the great merchandise buys we were able to deliver in Q3.

The gross margin rate was 45.0%, an increase of 260 basis points versus last year’s rate of 42.4%. This improvement was primarily driven by lower markdowns and higher markup, which were partially offset by increased freight costs. We do not expect to be able to generate the same level of year-over-year gross margin improvement in Q4, that we were able to achieve in Q3.

There are two reasons for this; first, while our clearance levels are down versus last year at the end of Q3, clearance inventory entering Q3 was extraordinarily low, due to our aggressive Q2 clearance strategy. That significantly reduced our clearance markdowns in August, which we don’t believe is repeatable in Q4.

Second, while we significantly exceeded our planned sales in Q3, sales for Q4 remain very uncertain due to the impact of the pandemic, which would affect our inventory markdown levels depending on how sales play out during the holiday season.

Product sourcing costs, which include the cost of processing goods through our supply chain and buying costs, we’re a $144 million in the third quarter of 2020 versus $90 million last year, increasing 360 basis points as a percentage of sales. As we indicated on last quarter’s call, we had expected significant deleverage in product sourcing costs for the third quarter — for a number of reasons.

Like most other retailers, we struggled at the end of the second quarter and into the third quarter, as we tried to get our DCs fully staffed and operating effectively. We prioritized inventory flow over cost efficiencies during the quarter, as our teams worked to get inventory back to appropriate levels in our stores and then to chase the positive trends we were seeing, as we experienced sales well above our planned levels during the quarter.

Supply chain costs, plus 280 basis points of the product sourcing cost deleverage. About 100 basis points or $16 million of this deleverage was driven by temporary COVID-related costs, which include recruiting expenses and incentives we put in place, as we worked to get our DC teams back to full strength. Wage rate increases since last year drove another 70 basis points of deleverage.

The balance of supply chain deleverage was driven by four additional factors: occupancy cost, as we added additional storage and processing space that is not yet fully utilized; a decrease in AUR; changes in product mix and a disproportionate increase in receipt volume processed, as we worked to catch-up on rebuilding our inventories. The remaining deleverage and product sourcing costs came from buying costs, as we lost sales leverage on the fixed cost base of our merchandising organization, while continuing to invest in improving our merchandising capabilities.

We do expect continued significant deleverage and product sourcing costs in the fourth quarter, though we could see some modest improvement in rate even at similar sales volumes, as the DC recruiting and temporary incentive costs will be behind us. The best way to think about modeling product sourcing costs for the fourth quarter is to assume a similar dollar level of product sourcing costs to what we incurred in the third quarter.

Adjusted SG&A was $495 million, versus $486 million last year, increasing 240 basis points versus the prior year. SG&A deleverage was primarily due to increases in-store related and corporate costs, including $20 million in COVID-related expenses. These increases were partially offset by a reduction in marketing expense. As the pandemic continues and seems likely to worsen during the fourth quarter, we will continue to plan our business and our inventory levels conservatively and adjust to the trends we see. While our SG&A expense will flex with our sales volume, we could see continued SG&A deleverage in the fourth quarter.

Adjusted EBIT decreased $81 million to $59 million in the third quarter, driven primarily by the lower sales volume and increased product sourcing costs. We did not repurchase stock during the quarter. We have $348 million remaining on our share repurchase program, which remains suspended. All of this resulted in diluted earnings per share of $0.12 versus income of $1.44 last year. Adjusted diluted earnings per share were $0.29 versus a profit of $1.53 per share last year.

At quarter-end, we had approximately $1.3 billion in cash, $250 million in borrowings on our ABL, $958 million on our senior secured term loan facility, base value of $805 million in convertible notes and $300 million in senior secured notes. We had unused ABL availability of approximately $292 million. We ended the period with total balance sheet debt of approximately $2.2 billion.

Merchandise inventories were $867 million versus $1,004 million last year, a 14% decrease. In the last few months, we have made an adjustment on how we classify our merchandise inventories. This reclassification is intended to better reflect our strategy to drive faster turns of in-store inventories, while at the same time taking advantage of great opportunistic buys, that will be stored for later release.

Using this updated classification, our merchandise inventories at the end of Q3 broke down as follows: first of all, in-store inventories; this includes inventory that is in our stores, on its way to stores or being processed at the DC to be sent to stores. These inventories were down about 20% on a comp store basis at the end of Q3. This was in line with our plan of down 20% to 25% versus last year.

Secondly, reserve inventories. This includes all inventory that is being stored for later release, either later in the season or in a subsequent season. This reserve inventory was up 8% at the end of Q3. It represented 25% of total inventory at the end of Q3, compared to 19% last year. I’ll talk more about this in a moment.

During the quarter, we opened 30 net new stores, bringing our total store count at the end of the third quarter to 769 stores. This included 30 new store openings and seven relocations. In the fourth quarter, we do not expect to open any new stores, but do expect to close eight stores, resulting in an expected fiscal year in store count of 761 stores. As compared to our outlook on our last earnings call, we still will open 62 new stores in fiscal 2020, but we decided to close two additional stores.

As discussed in the last earnings call, we still expect to open the 18 new stores in fiscal 2021, that were shifted from opening in fiscal 2020. We will have more to say on our 2021 expected new store openings, as well as our broader real estate strategy over the next several years, on our fourth quarter call in March.

Net capital expenditures were $188 million for the first nine months of fiscal 2020. Net capital expenditures are now expected to be approximately $245 million for fiscal 2020.

Now, I will turn to some comments on our outlook. As described earlier, the sales trend for the fourth quarter is very difficult to forecast. Our month-to-date comp for November is down low double-digits. We believe that this month-to-date trend has been negatively affected by the warmer year-over-year temperatures. But even once the weather turns around, the range of possible outcomes for the remainder of the fourth quarter is very wide. It is possible that the resurgence in COVID-19 cases and actions and restrictions taken by government authorities in response, could have a significant negative impact on the trend.

Given this uncertainty, we will not be issuing formal sales and earnings guidance again this quarter. We continue to plan the business conservatively; keeping tight control over liquidity; inventory and expenses. This posture gives us the flexibility from a liquidity and open-to-buy standpoint to flex up our receipts and opportunistic purchases, if we see a stronger sales trend than expected.

We were able to demonstrate that ability as we flexed up our receipts to chase September and October sales and we will take that same flexible approach to planning and reacting to what we see in the fourth quarter. On the other hand, if trends are below expectations, we will have the flexibility and liquidity to pull back on our purchases, if necessary.

As I explained a moment ago, our in-store inventories at the end of Q3 were down about 20% on a comp-store basis, which was in line with plan. During the fourth quarter, we will continue to manage in-store inventories conservatively versus last year. In contrast, we expect to significantly increase our reserve inventory. At the end of Q3, this inventory was up 8% versus last year. This increase would have been more significant, but for the fact that we deliberately pushed some of our reserve inventory purchases from Q3 into Q4. We did this for two reasons: first, to free up supply chain capacity for current and holiday merchandise; and second, because we believe that the buying environment for this merchandise could be even more attractive in the fourth quarter. If this turns out to be correct, then we estimate that reserve inventory by the end of January could be up more than 50%, compared to last year.

Finally, as we did last quarter, we can update you on certain fiscal 2020 cash flow and expense items, that may be useful for modeling purposes. Capital expenditures, net of landlord allowances are now expected to be approximately $245 million. We expect to open 62 net — 62 new stores, but now anticipate relocating or closing 28 stores, for revised total of 34 net new stores in fiscal 2020, previously we had expected to close or relocate 26 stores.

Depreciation and amortization expense, exclusive of favorable lease costs, is now expected to be approximately $225 million. And interest expense, excluding $24 million in non-cash interest on the convertible notes is now expected to be approximately $75 million.

With that, I will turn it over to Michael, for closing remarks.

Michael O’Sullivan — Chief Executive Officer

Thank you, John. As I wrap up my remarks, I would like to express my warm appreciation and gratitude to all our associates at Burlington. We continue to operate in the midst of a global health crisis, which is likely to continue to impact our lives in the months ahead.

This is a challenging time, but it is also a very exciting time at the company. There are a lot of very good things happening. The way that our associates have mobilized behind Burlington 2.0, has been particularly impressive and further reinforces my belief and confidence in our prospects over the next several years.

With that, I will turn it over to the operator for your questions. Operator?

Questions and Answers:


Thank you. [Operator Instructions] Our first question comes from Matthew Boss of JPMorgan. Your line is now open.

Matthew Boss — JPMorgan — Analyst

Great. Thanks and congrats on the improvement. Michael, so maybe any additional color that you can provide on the components of comp store sales in the quarter, traffic, basket size, average unit retail. I think would be very helpful if you could add any color?

Michael O’Sullivan — Chief Executive Officer

Sure. Well, good morning, Matt. Thank you for the question. You know, I’m going to start by reading the actual data and then I’ll provide some editorial commentary, so let’s see. The traffic for the quarter was off by more than 20%. Our average basket size in units was up by more than 20%. Our average unit retail — so the average price per unit was down about 10%. If you combine those items, the average transaction size in dollars was higher by about 10%, low double-digits and if you mix all of those variables together, of course you get minus 11% comp decline for the quarter, so that’s the data.

Let me, let me sort of offer up some conclusions that I would draw from this data. The first point I would make is that the decline in traffic versus last year is disappointing. It improved as we came out of August, but it was still weak in September and October. I think there are really two factors that drove that weakness: first, most obviously if you like, we’re in a pandemic. There are shoppers, who just are not going to be comfortable, coming back into a bricks-and-mortar environment until we get through this. Now we have very robust safety and social distancing programs in our stores and we’ve marketed these, but we realize that despite those measures, realistically, traffic is going to remain depressed until we get through the pandemic, so that’s point number one.

Point number two, I think we have to acknowledge that compared with our peers, we at Burlington, we’re not necessarily a top of mind destination for some of the key merchandise categories that shoppers are most interested in right now. Now, as I’ll describe in a moment, we’ve made huge progress in areas like home and casual apparel, but we recognize that in these businesses, we are starting from further behind versus peers.

The second conclusion that I would draw from the data though is much more positive and it’s — but I think we are doing — I think we are doing an excellent job driving business with the traffic that is coming into our stores. We’ve shifted our assortment and we’re offering great values, actually great values in many of the same categories that I just mentioned, categories that the customer wants to buy right now. We significantly expanded our home, active, casual, essentials and basics merchandise assortments. This enabled us to chase the trend in September and October.

Now, I think you can actually see the stronger value in the lower where you are and the higher basket size shows that the customers that are coming into the store are responding very well. They’re buying many more items and they’re spending more during each visit. So I think these are encouraging indicators, encouraging indicators of what might happen if and when traffic levels pick up, once we get through the COVID-19 pandemic.

Matthew Boss — JPMorgan — Analyst

That’s helpful. And then as a follow-up on the industry supply chain. So on the August call you talked about delivery delays from vendors. And how these been impacted your in-store inventory? I’m curious where we stand today and if these delays have dissipated?

Michael O’Sullivan — Chief Executive Officer

Sure. Yes, it’s a good question. That was a big part of the story on our last call. Let me chunk out my answer a little bit. I’ll start with a — with an update on our own internal supply chain, our own distribution centers. You’ll recall that in August we explained that along with many other retailers, we had run into significant staffing issues in our distribution centers and that those issues had really hampered our ability to get in-store inventories up to planned levels, as fast as we would have liked. The simple update here, is that those issues have been resolved. In Q3, we took a number of actions, including higher wage rates and on-boarding incentives and these actions worked. We’ve been very happy with how our distribution centers have been able to ramp up for peak holiday production in October and November month-to-date. And right now, obviously, we’re at that peak processing level. So, that’s the update on our own internal supply chain.

But the broader sort of industry-wide issues have not gone away. There are chronic delays in merchandise deliveries across the retail industry. I’m sure that you’ve heard this elsewhere. These delays have been driven by, I would say a number of factors; including ongoing staffing issues at vendor distribution facilities; timing issues, kind of, associated with the surge of orders that took place following the lockdown earlier this year; and then I would also say import delays, specifically related to congestion at the West Coast ports.

Now, we took a number of steps in the third quarter to, sort of, navigate our way around these issues. Remember, we’ve seen this movie before in Q2. So, we were aware of the risks. Our planners and buyers, I think did a very good job, juggling purchase orders and delivery dates. So at the end of the third quarter our in-store inventory levels were pretty much right on plan, but down 20% on a comp store basis.

The last point I would make is just stepping back and Matt, I’m sure you realize this, there is potentially a very important silver lining in the delays that I’ve just described. In the coming weeks, these delivery delays across the industry are likely to translate into off-price supply. This could become an attractive off-price buying opportunity and that’s actually one of the reasons why we pushed some of our reserve inventory purchases to later in the fourth quarter.

Matthew Boss — JPMorgan — Analyst

Great. Best of luck.

Michael O’Sullivan — Chief Executive Officer

Thanks Matt.


Thank you. And our next question comes from Ike Boruchow, Wells Fargo. Your line is now open.

Ike Boruchow — Wells Fargo Securities — Analyst

Hey, good morning guys. So, thanks for all the information, super helpful. I guess a couple of questions. The first one is about, if we could talk about the operating margins. I guess, it sounds like there is aspects of the Burlington 2.0, that should help drive margins higher overtime, but I think there’s also some expense headwinds you guys are alluding to supply chain and product sourcing cost, sounds like a big one, they can offset some of these gains, especially in the near-term. Just how should we think about the different factors and their impacts on margins and I have a follow-up after that.

Michael O’Sullivan — Chief Executive Officer

All right. Well good morning Ike, good to hear from you. I think, I’ll break down the question into two different time per [Phonetic] periods. In the short-term, what are our expectations for operating margins, specifically in 2021, in a moment, I’m going to ask John to address that. But first, let me talk about the longer term. What is the operating margin opportunity for Burlington over the next several years. Internally, as we’ve modeled the impact of Burlington 2.0, we’ve identified and sort of zeroed in on three main drivers of margin improvement. And we believe that these three drivers represent the lion’s share of the margin gap versus our peers.

The first is sales, of course the higher sales productivity, drives leverage. The steps that we’re taking to drive sales are the things that we’ve talked about, in particular, controlling our liquidity so we can chase trends and take advantage of opportunistic buys and heavily investing in merchandising capabilities, so we can deliver even stronger value across all categories and in particular, develop under penetrated categories, that’s the first lever.

The second lever is gross margin. We believe that we have a significant opportunity to turn our inventories faster, than we have historically and thereby drive lower markdowns. One aspect of this of course is, as I’ve just mentioned to drive higher sales. But the other critical enabler is tight control of inventory levels and also greater urgency in getting fresh receipts to the sales floor. If we do those things, I’m actually very confident we can drive faster inventory turns and significantly lower markdowns. I kind of feel like we’ve demonstrated that to some degree in the third quarter.

The third driver of margin improvement is lower occupancy costs. Our stores are bigger and less productive than our peers, again driving higher sales will help, but as I mentioned in the prepared remarks, we believe we have an opportunity to reduce the size of our store prototype, thereby reducing our occupancy expenses over time.

Now as part of Burlington 2.0, we have specific initiatives in place to go after each of the levers, I’ve just described. Over the next several years, we expect — I expect to make significant progress in driving improvements in our operating margin. But that said, these things never necessarily work in a straight line, there are going to be short-term headwinds and certainly, until we get through the pandemic, there will be challenges, either from deleverage on lower sales volumes or higher operating expenses, such as supply chain or COVID-related costs.

On our fourth quarter call, in March, we’ll provide an updated view on these headwinds for 2021. But it might make sense, but now maybe for John to provide some initial comments on what we think we may face next year.

John Crimmins — Executive Vice President and Chief Financial Officer

Sure, thanks Michael. And good morning, Ike. Obviously we still got a lot of work to do on our plan for next year, but I think we can share a little color, kind of, how we’re thinking about as we put together this year. Usually, when we start to build an annual plan, we’re going to set objectives based on what we want to achieve, compared to the current year. But since 2020 has been such a unique unusual year, we’re going to look back to 2019 as the base year for our 2021 plan. So, will focus on how 2021 is going to differ from 2019.

Again, normally, one of the first assumptions that you’d lock in on, would be comp sales growth, but we still have the pandemic going on, it seems to be getting worse before it’s likely to get better. We’re optimistic that, you know, there may be an end at site, but yes, it’s going to continue to impact all of retail and that’s going to make — sales is likely going to be a little bit of a roller coaster, as it’s been this year. So, this means, we’re going to have to plan conservatively and then we’re going to look to flex to the business trends that — as we see them develop.

Now the good news on that is, we’ve had some pretty good practice at doing that this year. So, that means we’re going to have conservative comp assumptions, whenever you have conservative comp assumptions, it’s going to be difficult to drive operating margin expansion and it’s going to be even more difficult in 2021, because we’re building a plan from a base year 2019. So, if you think about it, we will have experienced two years of fixed expense inflation increases. So, ignoring any other cost headwinds, we’d have to cover that with adequate sales growth before we begin to see our normal expense leverage.

And while we do expect some of the temporary COVID-related expenses to end when the pandemic ends, we could see that we will have some headwinds that are still going to be there. So, what we can see now, we’ve seen supply change wage pressures that we have had to respond to in this year and we’ve seen a lower AUR trend, as we’ve — Michael just talked about, for what we’ve seen in the third quarter. We do expect the lower AUR to drive sales, as Michael described, but it also means that there is more units to process per dollar of sales. While we’re confident that over time we can mitigate these expense pressures, we’ve got a history of, kind of, always being able to figure that out, but some of our mitigating actions like re-engineering production processes or automating others, are going to take a little longer, they’re going to have some lead time. So again, compared to 2019, we’re expecting to see pretty significant deleverage in supply chain expenses in 2021. As I said a moment ago, we still have a lot of work to do over the next few months and we’re going to be in a much better position to share more detail on our sales and our expense plans during our March call.

Ike Boruchow — Wells Fargo Securities — Analyst

Got it. Thanks John. And just one quick follow-up on AUR. I think you had talked about lower AUR in the quarter. Can you up — could you expand on that a little bit, it sounds like you expect this to continue into ’21. Just a little bit more detail on that topic would be great.

John Crimmins — Executive Vice President and Chief Financial Officer

Sure, Ike. Yes, first, let me kind of talk about what we saw in the third quarter a little bit on AUR. Yes, I think the biggest driver this — our mix of merchandise, consumers are interested in different things now than they were prior to the pandemic. Our strongest merchandise categories, right now, things like casual, apparel, active, athletic, basics, essentials, home merchandise, all the ones that you think of, when people are not back to their normal lives. On average these have lower AUR than the merchandise categories that haven’t been as strong. So, we kind of traded off sales in these lower AUR categories and we’re not — we’re seeing, not as strong sales in things like career ware, structured apparel, apparel tailored clothing, the more dressy categories. And in general, more dressy tends to mean higher price and in general, less dressy tends to mean lower price, so that’s one of the drivers.

The second driver would be our pricing. We’ve been working across all our merchandise categories to have sharper, more competitive pricing. As Michael has been talking about, we believe that in off-price, the most effective way to drive sales is to offer the best possible merchandise value. That’s what the customer really cares about. The last couple of quarters, that’s what our merchants have been focused on, offering great value and it’s been working. As Michael mentioned, the number of units per basket rose by more than 20% in the quarter and we think that’s directly related to the better values that we offered.

Looking ahead now, we think the merchandise mix might at some point shift back in the other direction, when the pandemic is over. You’d certainly expect trends to go back to some degree of normal, maybe a different new normal. But, at some point, people will have a desire to dress up a little more again. If that does happen, then we’d expect that mix impact in our AUR, it may come back the other way. But if it does happen, there is a good chance that potentially good news would be offset by the downward pressure on AUR, as we continue to execute the Burlington 2.0 strategy, looking to drive sales by offering that great merchandise value at great prices. So, that would likely mean our AUR, which stayed below historical levels, netting the two together as we look forward.

Ike Boruchow — Wells Fargo Securities — Analyst

Thanks, John. Thanksgiving.

John Crimmins — Executive Vice President and Chief Financial Officer

Thanks, Ike. Thanks.


Thank you. And our next question comes from John Kernan of Cowen. Your line is now open.

John Kernan — Cowen & Company — Analyst

All right. Good morning. Hope everyone is ready for Thanksgiving, the holiday season. I have a question for Michael and then one for John, if I can. So just first, Michael, what’s your assessment of merchandise availability? I think everyone is interested in what you’re seeing right now, but also on the longer-term outlook. Some of the publicly — public vendors have talked about, taking a more conservative approach going forward, as it relates to inventory going into the off-price channel. Are you concerned that this is constraining to your growth overall?

Michael O’Sullivan — Chief Executive Officer

Good morning, John. Good question. John, you’ve followed off-price retail for a long time. So I think you’ll know that availability has always been the age old question in off-price, certainly, if you go back 30-years and the concern has always been that off-price retailers will run out of supply and clearly that has not happened, off-price has achieved a huge growth over that period.

Let me talk about the reasons why. But before I do, let me address the short-term availability first and then I’ll talk about the longer-term. Short-term availability, I would say that the quick answer is it — in the short-term, overall, the availability of off-price merchandise has been and continues to be very strong. We are pleased with the opportunities that we’re seeing. We said we are happy with the assortments and the values in our stores. Now, that’s not to say that there aren’t some gaps, some brands, some categories where we’d like more supply, there always are, but that’s the nature of off-price, it’s always off-price supply is always a little lumpy. But overall, I would characterize availability now and right now is very good.

But I think the more important part of your question was the longer term, we have, here at Burlington we have ambitious growth plans over the next several years. We believe, as I described in my prepared remarks, that we have an opportunity to take significant market share in the years ahead. So it’s a good question, do I think we will be constrained by merchandise supply? No, no, I really do not think that. As you’d expect, over the years, I’ve spent quite a lot of time looking at this issue of off-price and supply, and when I hear concerns about supply in off-price, I understand what triggers those concerns, but I have to say I’m very skeptical about those concerns and my skepticism is really based on two factors.

Number one, I think it’s very important to understand that our relationship with our vendors is very strong. It is a partnership. It’s not transactional, it’s a long-term relationship. For the categories that we sell, the skew count, the complexity, the lead times, all of those factors make it very difficult for vendors to precisely forecast how many units of the style to produce. Now because of the off-price channel, they actually don’t have to get this right, they have a — they have an outlet, a partner for excess merchandise for overruns, they have a partner for cancelled orders. So the way to think about this is, we lower the risk for them. We want them to be successful and we can help them grow their businesses. So those relationships really are partnership.

The second point I would make and this is very important, is that we compete in many different categories. We have thousands of vendors and brands that we do business with. We aren’t reliant on any single, on only one vendor, our largest vendor is no more than a small percentage of our sales. So it could absolutely be true, an individual vendor might cut back, but that wouldn’t really make much of a difference to us in the biggest scheme of things. In fact, as we grow our vendor base — I’m sorry, as we grow, I think our vendor base is likely to increase significantly as well. In some of our most important underpenetrated businesses, businesses like home or beauty, the underlying vendor base is actually very fragmented. You have a lot of very small vendors. So, as we grow those businesses in particular, I would expect that the vendor count will increase actually at a much greater rate, than it has in the past.

With all that said, with everything I’ve just said, my expectation is that there will be times when there are specific brands or specific vendors that have more or less availability, that’s always going to be true. As an off-price retailer, we recognize that, that means that — there will be gaps in our assortment, but to come back to your main question, am I concerned that this will constrain our growth? No, for the reasons I’ve described, I’m really not.

John Kernan — Cowen & Company — Analyst

All right. Thanks, Michael. Second question is for John, just on the 25,000 square foot prototype. It seems like a big opportunity, interested in hearing more about the thinking in the financial planning that led to the smaller format. And then in particular, any early information or expectations around productivity, profitability and then the potential store numbers over time?

John Crimmins — Executive Vice President and Chief Financial Officer

Well, sure John. Thanks for your question. Good question. John, you’ve been following us since the beginning. So, I don’t think I have to tell you that we’ve got a pretty good history of continuously reducing the amount of inventory we’ve had in our stores. It’s going on for many years now and as we’ve been doing that, we’ve been able to reduce our store size each year for the last, however back — however, far back you want to go. To the point, at this year, our average store size is just under 40,000 square feet. So, this is really been, kind of, a learning opportunity for us, we’ve been continuously reducing the box size, operating with leaner inventories and learned quite a bit on the operating side.

And then now we’ve got our Burlington 2.0 off-price for potential strategy, where one of the main principles is, to run with even leaner inventories. So, this leaner inventory is — and the confidence that we have in that is, I guess you would call it an enabler really, of how much far that we think we can take our smaller box size. We’ve been really pleased with the initial progress we’ve seen, as we’ve started to work on these initiatives. So, this stuff altogether just gives us added confidence in our ability to do this in a little bit of a clearer path to the further in-store inventory reductions. So, all together, kind of higher confidence and better visibility to how we can get to this 25,000 square foot prototype.

So, while this stuff has been going on, particularly in the past year, our real estate team, our store design, inventory planning and store operations teams, have been working on an actual prototype for the 25,000 square foot store, and we feel really good about the detailed merchandising and operational plans that they’ve been developing. So, we’re really excited about the potential that we see for the smaller stores.

In terms of the actual store level economics in our opening plans, you are going to wait until our next call in March to get more specific on that, but we do believe the smaller prototype offers potential for higher sales productivity and better expense efficiency. And we think that over time, it’s likely become a central element of both our new store and our existing store relocation plans, as we, kind of, sort through our portfolio.

John Kernan — Cowen & Company — Analyst

Excellent. Thank you.


Thank you. Our next question comes from Lorraine Hutchinson of Bank of America. Your line is now open.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Thank you. Good morning. So Michael, you spoke about traffic declines in the quarter. How concerned are you that shopper behavior may have changed during the pandemic? Do you think some of the business that has moved online wont come back to bricks-and-mortar?

Michael O’Sullivan — Chief Executive Officer

Hi, Lorraine. I think it’s a very good, very important question. There is no doubt, we could all see that e-commerce has grown significantly, because of the pandemic and my guess is that, some of the share gain will be permanent. I think some of this share shift would likely have happened anyway, over the next few years, but the pandemic accelerated it. And I don’t think, as I said in my remarks, that I do not think, that as we get through the pandemic, shopping patterns will just go back completely to the way that they were.

Now, I actually think that share shift there — that share gain by e-commerce is going to have the effect of critically undermining full price bricks-and-mortar retailers, especially mall-based retailers. It seems likely that will drive a wave of rationalization and store closures in the retail industry. I think we’re just really seeing the start of that.

The most important question for us is, where do these customers go? When a typical department store or a specialty retailer store closes. Now, for sure some of that business will go online, permanently, as I said in my prepared remarks. That seems especially likely for more affluent time-starved shoppers, if you like. But, our own hypothesis is that, many of the more value-oriented shoppers will find their way to off-price, if we could offer them great assortments at great values, then I actually think we can grow and take market share, once we get through the pandemic.

Now the underlying premise of what I’ve just said, is that we can satisfy these value-oriented shoppers more effectively and more competitively than e-commerce. And actually I’ve had this conversation with many, many of the investors on this call, we operate on a $11 and $12 average unit retail business, with a very broad fashion assortment. It is economically and strategically very difficult for an e-commerce business to compete with us, at these price points, in the categories where we compete.

The other point that I would make is that, this isn’t just a conceptual argument, it’s actually what has been handling for several years now. E-commerce has been growing for some time and the full price bricks-and-mortar department store and specialty store channels have been shrinking for some time. Meanwhile off-price retail has been growing and taking share. We at Burlington, for example, have been growing our top line in the high single-digits each year for the last several years. So, bring it all back together, we believe that in the aftermath of the pandemic, we could see an acceleration of the trends that I’ve just described, not a reverse all of them.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Thanks. And then for John, I appreciate the breakdown of product sourcing cost, that you gave in the comments. I was just curious, what proportion of these costs do you think might be permanent?

John Crimmins — Executive Vice President and Chief Financial Officer

Yes. Okay, Lorraine, thanks for the question. So, it’s complicated so I’ll, kind of, go through some of the stuff I said on the call, then maybe put it in, kind of, go forward context as well. So, let me just start reminding what’s in product sourcing costs. For us, that includes all the cost of our supply chain and all the cost of our merchandising operations. And as I said in our prepared remarks, that overall, the product sourcing costs altogether de-levered by 360 basis points during the third quarter. So supply chain drove 280 bps of that deleverage, about a 100 basis points or $16 million of that, we consider to be temporary COVID-related costs.

And in this bucket, we include the temporary recruiting costs and wage incentives that we had to use to get our DCs properly staffed quickly, to help get our store inventories back to appropriate levels, along with some costs related to the safety protocols that we put in place to protect our DC associates. About 70 basis points of the supply chain piece of the deleverage were related to the wage increases that we’ve had to do, actually since the third quarter. We had some wage increases that we have planned for this year and actually put in place earlier in 2020, but then we had some incremental costs that was in response to changes in the DC labor market during the pandemic, as the market became so much more competitive.

So, the adjustments we’ve made, we think have been successful in getting our DCs properly staffed and we believe our DC labor rates are now properly positioned. But of course, this piece, it’s a permanent wage increase. So, that is going to be part of our expense structure as we think about moving forward. The other factors causing the reminding [Phonetic], may be 100 bps or so, of supply chain deleverage were occupancy deleverage, the decrease in AUR, changes in product mix, and an increase in receipts processed versus sales we had during the quarter as we rebuilt our inventories back to appropriate levels. So, first the occupancy deleverage, that’s — we opened a couple of facilities that aren’t yet fully utilized. So that’s the piece that we would expect this to get better over time, as we move toward full utilization. One was for our processing and one was more for storage.

But longer term, as you would expect, we’re periodically we do bring other new facilities online. So you, kind of, go through a cycle, deleverage, then they hit, kind of, capacity and then eventually if they’re efficient as we expect them to be, they would actually help leverage. Of the other components, the one that from a go-forward standpoint, I think about the most, is the decrease in AUR. But as we’ve said, it’s not necessarily all bad news. While a smaller AUR does translate to more units and higher supply chain costs. Yes, one of the drivers of the decrease is our focus on delivering better value to our customers, which of course should help drive sales and lead to fewer markdowns.

So, as you would expect, we are looking at initiatives that we can pursue within our supply chain to try and offset some of these headwinds. But some of these initiatives, especially as it relates to driving significant productivity, efficiency increases, they’re going to have some lead time. We’re going to finalize our financial plan for 2021, as I said earlier, over the next couple of months, but we still got a lot of work to do. Having said that, we are expecting significant deleverage headwind to the supply chain, compared to our 2019 expense structure, as I shared a little earlier. So, that’s the supply chain piece of product sourcing costs.

In addition to that 280 basis points, we had 80 basis points of deleverage from lost sales leverage on our fixed merchandising organization costs and from Burlington 2.0 investments, we continue to make — to improve our merchandising capabilities, that we think are going to be well worth it, when we get to the other side of the pandemic. So typically, we’d look to offset incremental investments in the year that we’re making them, with efficiency savings, but we really didn’t push that this year. We had so much going on with COVID, that we wanted to be sure we’re spending adequately in some of the places like store payroll, where we may have pushed for efficiency in a different year.

Lorraine Hutchinson — Bank of America Merrill Lynch — Analyst

Thank you.


Thank you. And our last question comes from Kimberly Greenberger of Morgan Stanley. Your line is now open.

Kimberly Greenberger — Morgan Stanley — Analyst

Great. Thank you. And thank you so much for all the detail today. It’s been extremely helpful. Michael, I wanted to just reflect back on the Burlington 2.0 strategy that you laid out roundly a year ago and particularly focused on the inventory journey, because this year has obviously brought an unprecedented opportunity, let’s say, to maybe accelerate what you had thought might be a three or four, or I’m not sure, maybe even a five-year journey toward ever more efficient levels of inventory in store with faster turns. COVID perhaps accelerated the journey. And I’m wondering, if you can reflect on that and if you can share with us the way you’re thinking about the impact of 2020 on that inventory journey. And do you think in some ways that it’s accelerated your learnings, your insight and it will allow you to get to those leaner in-store inventories with faster turns maybe a year or two in advance of those original targets? Thank so much.

Michael O’Sullivan — Chief Executive Officer

Good morning, Kimberly, nice to hear from you. You’re right. Actually, I joined Burlington just over a year ago. So, I just celebrated my one-year anniversary. And maybe I should start out by saying it’s been a heck of a year. But it’s — joking aside, let me sort of address the progress that we’ve made over the past 12 months versus what my expectations might have been back then.

The first thing I’d say is that I’m very pleased. The thing I’m most pleased about is that we have — at Burlington, I feel like we have a very clear direction. We have a — what I’m going to call a transformational strategy. It’s a strategy that’s well understood and has a huge amount of support and traction within the company. So, I feel like we know where we’re going.

Secondly, and this kind of gets to your question, despite everything that’s happened this year and the challenges we faced, I think, we’ve been able to make pretty significant progress against this strategy, and some of that progress has come from — has come in the form of real changes that we’ve made to the business, greater focus on value; faster turns; more liquidity; more aggressive chase; greater urgency; and getting receipts to the sales floor. Well, all of those things are real, and in some ways, they’ve been accelerated by the pandemic and by the issues and challenges we’ve faced. We’ve also been able to make progress in some other areas like some of the initiatives that I talked about earlier that are at a, sort of, earlier stage of development and implementation. Those are important. Those are going to be important in the years ahead.

But, if I narrow it down to your specific question on inventory, I mentioned — in response to an earlier question, I mentioned that as we think about margin opportunity with Burlington 2.0, we really think about that margin opportunity in three buckets, lower markdowns; higher sales; and lower occupancy. And if you were just to — at a very high level, say where is the margin improvement, quantify the margin improvement across those three, I would say, it’s a third, a third, a third. So I think a third of the improvement can come from greater sales productivity, a third from lower occupancy and a third from lower markdowns.

I feel like we’ve made a lot of progress on that lower markdowns piece this year, but I want to temper my answer a little bit. There have been some very unusual circumstances that have helped us get there this year. We’ve ended up turning inventories faster than we ever would have planned. So, I think we’ve made progress this year, but we really need a year or two to consolidate that progress and to make sure that the gains that we’ve made are captured over the longer term. But, that’s how I would characterize that. I feel like we’ve made much more progress on that inventory piece than I would have expected in a relatively short period of time. But, it’s too early to declare victory. It’s too early to take back to the banks just yet. We need a bit of time to really consolidate around that.

Kimberly Greenberger — Morgan Stanley — Analyst

Fantastic. Thanks for the insight.


Thank you. And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Michael O’Sullivan for any closing remarks.

Michael O’Sullivan — Chief Executive Officer

Thank you, everyone, for joining us on the call today. We appreciate your questions. We look forward to talking to you again in early March to discuss our fourth quarter results. Meanwhile, I know that it’s going to feel different and maybe a little subdued this year, but I would like to wish you and your families a very happy Thanksgiving. Thank you.


[Operator Closing Remarks]


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